The Journal of Business, Entrepreneurship & the Law

Volume 2 | Issue 2 Article 5

4-20-2009

Rural Banking: Designing an Effective LegalFramework for MicrofinanceIan Davis

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Recommended CitationIan Davis, Rural Banking: Designing an Effective Legal Framework for Microfinance, 2 J. Bus. Entrepreneurship & L. Iss. 2 (2009)Available at: http://digitalcommons.pepperdine.edu/jbel/vol2/iss2/5

RURAL BANKING: DESIGNING AN EFFECTIVE LEGAL FRAMEWORK FOR

MICROFINANCE

IAN DAVIS1

I.Introduction to Microfinance .............................................................................. 395 II.Microfinance Regulation and Supervision ........................................................ 398

A. Challenges for microfinance regulation ............................................ 401 B. Benefits to microfinance regulation .................................................. 404

III.Aspects of a Sound Legal Framework for Microfinance ................................. 406 A. Microfinance services should be integrated with the formal

financial sector .................................................................................. 406 B. Regulation should be based on a tiered approach ............................. 409 C. The framework should facilitate an easy transition from NGO to

formalized bank ................................................................................. 412 1. Example of K-Rep Bank ............................................................. 413 2. Example of BancoSol ................................................................. 414

D. There should be no interest rate cap .................................................. 416 IV.The Microcredit Regulatory Act of 2006 ......................................................... 419 V.Conclusion ........................................................................................................ 423

Approximately 1.2 billion people live in extreme poverty, surviving on less

than $1 per day.2 In emerging markets, commercial banks generally serve only ten to twenty percent of the population, excluding eighty to ninety percent of the population from the formal financial sector.3 Many in this “un-banked” population could benefit from access to financial services.

In most developing countries, rural financial markets are based partially on a foundation of law and partially on a non-legal foundation of extra-legal (and sometimes illegal) activities.4 These legal and non-legal foundations directly

1 2009 JD candidate and Fellow of the Geoffrey H. Palmer Center for Entrepreneurship & the Law at Pepperdine University School of Law.

2 ROBERT PECK CHRISTEN & DOUGLAS PEARCE, CONSULTATIVE GROUP TO ASSIST THE POOR (CGAP), MANAGING RISKS AND DESIGNING PRODUCTS FOR AGRICULTURAL MICROFINANCE: FEATURES OF AN EMERGING MODEL 1 (2005), http://www.cgap.org/gm/document-1.9.2705/ OccasionalPaper_11.pdf.

3 See MARGUERITE S. ROBINSON, THE MICROFINANCE REVOLUTION: SUSTAINABLE FINANCE FOR THE POOR 6 (World Bank Publication 2001).

4 HEYWOOD W. FLEISIG & NURIA DE LA PEÑA, LEGAL AND REGULATORY REQUIREMENTS FOR EFFECTIVE RURAL FINANCIAL MARKETS 1 (Ctr. for the Econ. Analysis of Law 2003). This principle is illustrated in detailed fashion in HERNANDO DE SOTO, THE MYSTERY OF CAPITAL: WHY CAPITALISM TRIUMPHS IN THE WEST AND FAILS EVERYWHERE ELSE (Basic Books 2000). De Soto explains that most businesses in developing economies function in the extra-legal sphere, meaning they do not enjoy

2009 MICROFINANCE LEGAL FRAMEWORK 395

influence the operation of rural financial institutions.5 This comment will discuss the intersection between rural finance and legal systems. The focus of the paper will be on an emerging legal issue in developing countries: integration of microfinance institutions with the formal legal framework. The comment argues that the benefits of microfinance regulation outweigh the costs and is divided into four sections: The first section is an introduction to microfinance; the second section provides an overview of the issue of microfinance regulation;6 the third section offers suggestions for specific aspects of a favorable legal framework for microfinance;7 the final section analyzes an example of an effective microfinance regulation law.8

I. INTRODUCTION TO MICROFINANCE

Microfinance organizations aim to help individuals rise out of poverty.9 Providing access to credit for low income groups that have traditionally been excluded from financial markets allows the poor to “expand and diversify their

legal protection and benefits since they are not registered as legal entities. De Soto describes the predicament: “[e]xtralegal businesses are taxed by the lack of good property law and continually having to hide their operations from the authorities. Because they are not incorporated, extralegal entrepreneurs cannot lure investors by selling shares; they cannot secure low-interest formal credit because they do not even have legal addresses.” Id. at 155.

5 FLEISIG & DE LA PEÑA, supra note 4, at 1. The legal structure of rural financial institutions influences the institutions’ legitimacy and ability to operate efficiently. Additionally, if institutions operate in the extra-legal sphere, they live in fear of government detection. See DE SOTO, supra note 4, at 155. De Soto states that such fear makes it difficult for institutions to reach their potential, as “underground entrepreneurs cannot openly advertise to build up their clientele or make less costly bulk deliveries to customers.” Id.

6 See infra note 34. 7 See infra note 104. 8 See infra note 199. 9 The website of Unitus, a leader in the microfinance industry, provides an overview of the history

of microfinance: Microfinance emerged in the 1970s as social innovators began to offer financial services to the working poor — those who were previously considered “un-bankable” because of their lack of collateral. Once given the opportunity, not only did clients of [microfinance institutions] expand their businesses and increase their incomes, but their high repayment rates demonstrated that the poor are capable of transforming their own lives given the chance. This model of lending disproved all conventional thinking. Microfinance was born. Since then, microfinance has become one of the most sustainable and effective tools in the fight against global poverty.

Unitus, The Microfinance Solution, http://www.unitus.com/unitus-in-action/background-poverty-and-microfinance/the-microfinance-solution (last visited Mar. 1, 2009).

Further, the Unitus website briefly explains the fundamentals of microfinance: The most common microfinance product is a microcredit loan — usually less than $100. These tiny loans are enough for hardworking micro-entrepreneurs to start or expand small businesses such as weaving baskets, raising chickens, or buying wholesale products to sell in a market. Income from these businesses provides better food, housing, health care and education for entire families, and most important, additional income provides hope for a better future.

Id. Unless otherwise indicated, this paper refers only to microfinance in developing countries. Microfinance in wealthy countries presents drastically different issues.